Theories of Tax Incidence

What is Tax Incidence ?

Tax Incidence or Incidence of Tax refers to the money burden of the tax. Simply put, tax incidence relates to the final resting place of the tax. When a tax is levied, its money burden falls on one individual or another. Under tax incidence, one tries to find out where the burden of money actually falls or who bears the money burden of the tax. 

Impact of Tax Incidence and Incidence of Tax Incidence are two different concepts. The impact of tax falls on the person who pays the tax, first. However, the incidence of tax falls on the person who ultimately pays the tax. It is because the person who pays the tax in the first instance does not necessarily bears the money burden of the tax. In simple terms, the impact is the original burden of the tax; however, the incidence is the ultimate burden of the tax. 

For example, when the government levies export duty on rice, which is first paid by the rice mill owner. Therefore, the impact of export duty on rice is on the mill owner. But, it does not mean that the incidence of export duty will also fall on the mill owner. The mill owner will now pass on the export duty burden to the consumer by charging higher prices. It means that the owner will add the amount of export duty to the price of rice and then charge it from the consumer. Thus the incidence of export duty on rice will be borne by the consumer. 

Theories of Tax Incidence

The three main theories of tax incidence are Concentration Theory, Diffusion Theory, and Modern Theory.

1. Concentration Theory:

The Concentration Theory states that each tax ultimately tends to get concentrated on a specific class of taxpayers, irrespective of the person or commodity on which these taxes are originally imposed. According to the Physiocrats of France, each type of tax imposed on people ultimately fell on the net income from land. Simply put, whether the tax is imposed on a commodity or a person, it would ultimately fall on land-owning classes. These Physiocrats also believed that agriculture was the only occupation which is productive and gives rise to economic surplus. Therefore, according to them, no matter if tax was imposed on a commodity or a person, through the process of tax shifting, it would ultimately fall on land. Based on these grounds, the Physiocrats suggested that a single tax should be levied on the net income from land and all other taxes on the people should be abolished. 

However, this theory of Physiocrats has been criticised because agriculture is not the only occupation that is productive, as it solely does not give rise to economic surplus. Also, a single tax imposed on land would not provide revenue that is enough to fulfil the requirements of a Modern Welfare State. However, some truth lies in this theory (concentration theory). The concentration theory emphasises an essential point; i.e., ultimately all taxes are paid out of economic surplus. Besides, if the economic surplus is missing, then various attempts would be made to the transfer tax burden on the shoulders of others.

2. Diffusion Theory:

Diffusion Theory is just of the concentration theory and was propounded by various economists like Mansfield and Canard. This theory states that the tax burden automatically gets distributed in society through tax shifting. To explain this theory, Mansfield described the tax as a stone or pebble which when thrown into a pond or lake creates a series of circles, and each circle leads to the other circle. This process of a series of circles goes on till the original circle coincides with the whole lake. The same thing happens in the case of taxes. When the government levies taxes on a specific point, its burden does not get confined to a specific point; instead, it gets distributed widely among the different sections of society. This, as a result, automatically diffuses the tax burden throughout society, making it impossible to keep the tax confined to a particular point. Canard tried to explain the substances of this theory by comparing tax imposition to blood extraction from a human vein. Even though the blood is extracted from a single vein, the loss of blood automatically gets spread over the entire human body and it continues to remain in equilibrium. The explanation of Diffusion Theory by both Mansfield and Canard simply states that the tax burden is shifted and reshifted until it is spread throughout society. Therefore, there is no such use in studying the problem of tax incidence in public finance.

The diffusion theory prefers commodity or indirect taxes over personal or direct taxes because the possibility of diffusion of the burden is more in indirect taxes (through trade and exchange). Similarly, this theory supports old taxes instead of new taxes. It is because, through the passage of time, the tax burden of old taxes has already got diffused in society; however, till the burden on new taxes gets spread in society with the lapse of time, it causes upsets.

Despite its advantages, the critics rejected Diffusion Theory due to the following reasons:

• Firstly, this theory does not believe that the tax levied by the government falls on each individual based on their ability to pay. In fact, many times, the tax burden falls on an individual beyond his capacity, resulting in discontent and dissatisfaction in society.  
• Another reason behind the rejection of this theory is that the critics do not agree with the view of this theory that there is no use in studying tax incidence. As we know that modern governments majorly aim at achieving the objective of maximum social advantage, in order to achieve this objective, it is essential for the government to check that the tax burden is borne by different sections of society based on their ability to pay. Therefore, it is not possible to ignore the issue of tax incidence.
• The third reason behind the rejection of diffusion theory is that it overlooks the fact that it is not possible to shift all taxes in exchange transactions. This is possible only under some circumstances. In simple terms, it is not possible to automatically diffuse the tax burden in society.
• The last reason behind its rejection is that the theory assumes there is perfect competition in the market, which is an unrealistic assumption. As there exist monopoly and monopolistic competition in the market, there is a check on the automatic diffusion of tax in society.

3. Modern Theory:

The Modern Theory of Tax Incidence primarily deals with the incidence of commodity taxation. This theory states that one can pay tax out of surplus only. It means that, if a taxpayer is enjoying a surplus, he will pay the tax out of that surplus. However, if the taxpayer does not enjoy a surplus, he will shift the tax burden on the shoulders of someone else. Besides, the tax imposed on a commodity is an essential element in its production cost. Therefore, the commodity’s price must cover it up. Simply put, the price of a commodity consists of the tax levied on it. 

One thing that should be kept in mind is that the tax incidence on a commodity cannot be shifted without making some transaction with another party/ consumer. It means that without making a transaction tax incidence cannot be shifted in a forward or a backward direction. Therefore, tax shifting depends upon the process of pricing. As we know that pricing is the function of the forces of demand and supply, based on this fact, the modern theory of incidence is considered as part and parcel of the theory of pricing. 

The process of shifting in commodity taxation is quite common and widely spread. The tax burden either falls on the buyer or the seller. If the price of the commodity increases by the amount equal to the tax, then the tax incidence or money burden is put wholly on the buyer. If the price of the commodity does not increase at all, then the tax incidence or money burden is put entirely on the seller. However, if the price of the commodity increases by an amount less than the tax, then the tax incidence or money burden is put partly on the buyer and partly on the seller.